Perspectives on where our world is heading from a vantage point in Denver, Colorado.

16 May 2011

Defined Benefit Promise In ERISA Plan Must Be Kept

CIGNA, a finance and insurance company, converted its retirement plans covered by ERISA, from a defined benefit plan to a superficially similar defined contribution plan called a "cash balance" plan.

The retirement plan beneficiaries sued, claming that the new plan deprived them of benefits that they had earned under the old plan. A federal trial court agree and reformed the plan to remedy the shoftfall. The U.S. Supreme Court, in an opinion issued today, agreed that any plan beneficiary who was actually harmed by the loss of benefits they had earned under the defined benefit plan that were forfeited in the cash balance plan was entitled to an equitable remedy, but found that the specifics of how the federal trial court went about calculating that remedy was incorrect.

The ruling has broad applicability for the many large and medium sized employers that have converted defined benefit plans to cash balance plans on a model similar to that used by CIGNA, although the ultimate remedy is likely to be somewhat less rich than lower court rulings in the CIGNA case had suggested. As the U.S. Supreme Court explained (citations omitted):

CIGNA . . . told its employees that they would “see the growth in [their] total retirement benefits from CIGNA every year,” that its initial deposit“represent[ed] the full value of the benefit [they] earned for service before 1998,” and that “[o]ne advantage the company will not get from the re-tirement program changes is cost savings.” In fact, the new plan saved the company $10 million annually (though CIGNA later said it devoted the savingsto other employee benefits). Its initial deposit did not “represen[t] the full value of the benefit” that employees had “earned for service before 1998.” And the plan made asignificant number of employees worse off in at least the following specific ways:

First, the initial deposit calculation ignored the fact that the old plan offered many CIGNA employees the right to retire early (beginning at age 55) with only somewhat reduced benefits. This right was valuable. For example, as of January 1, 1998, respondent Janice Amara had earned vested age-55 retirement benefits of $1,833 per month, but CIGNA’s initial deposit in her new-plan individual retirement account (ignoring this benefit) would have allowed her at age 55 to buy an annuity benefit of only $900 per month.

Second . . . the new plan adjusted CIGNA’s initial deposit downward to account for the fact that, unlike the old plan’s lifetime annuity, an employee’s survivors would receive the new plan’s benefits (namely, the amount in the employee’s individual account) even if the employee died before retiring [by] multiplying the otherwise-required deposit by the probability that the employee would live until retirement—a 90 percent probability in the example of our 32-year-old. And that meant that CIGNA’s initial deposit in our example—the amount that was supposed togrow to $120,500 by 2031—would be less than $22,000,not $24,000 (the number we computed). The employee, of course, would receive a benefit in return—namely, a form of life insurance. But at least some employees might have preferred the retirement benefit and consequently could reasonably have thought it important to know that the new plan traded away one-tenth of their already-earned benefits for a life insurance policy that they might not have wanted.

Third, the new plan shifted the risk of a fall in interest rates from CIGNA to its employees. Under the old plan, CIGNA had to buy a retiring employee an annuity that paid a specified sum irrespective of whether falling interest rates made it more expensive for CIGNA to pay for that annuity. And falling interest rates also meant that any sum CIGNA set aside to buy that annuity would grow more slowly over time, thereby requiring CIGNA to set aside more money to make any specific sum available at retirement. Under the new plan CIGNA did not have to buy a retiring employee an annuity that paid a specific sum. The employee would simply receive whatever sum his account contained. And falling interest rates meant that the account’s lump sum would earn less money each year after the employee retired. Annuities, for example, would become more expensive (any fixed purchase price paying for less annual income). At the same time falling interest meant that the individual account would grow more slowly over time, leaving the employee with less money at retirement.

Of course, interest rates might rise instead of fall, leaving CIGNA’s employees better off under the new plan. But the latter advantage does not cancel out the former disadvantage, for most individuals are risk averse. And that means that most of CIGNA’s employees would have preferred that CIGNA, rather than they, bear these risks.

The amounts likely involved are significant. If, in our example, interest rates between 1998 and 2031 averaged 4 percent rather than the 5 percent we assumed, and if in 2031 annuities paid 6 percent rather than the 7 percentwe assumed, then CIGNA would have had to make an initial deposit of $35,500 (not $24,000) to assure that employee the $11,667 annual annuity payment to whichhe had already become entitled. Indeed, that $24,000 that CIGNA would have contributed (leaving aside the life-insurance problem) would have provided enough money to buy (in 2031) an annuity that assured the employee anannual payment of only about $8,000 (rather than $11,667).
We recognize that the employee in our example (like others) might have continued to work for CIGNA after January 1, 1998; and he would thereby eventually have earned a pension that, by the time of his retirement, wasworth far more than $11,667. But that is so because CIGNA made an additional contribution for each year worked after January 1, 1998. If interest rates fell (as they did), it would take the employee several additional years of work simply to catch up (under the new plan) to where he had already been (under the old plan) as of January 1, 1998 . . .

The District Court found that CIGNA told its employees nothing about any of these features of the new plan—which individually and together made clear that CIGNA’s descriptions of the plan were incomplete and inaccurate.

The implication seems to be that on remand the trial court may use equitable remedies to cure these deficiencies.